When a 10K is just a walk in the park

Commentary: With inflation in tow, Dow 10,000 isn't what you think

BOSTON (MarketWatch) -- The Dow Jones Industrial Average is back within spitting distance of 10,000. There's a lot of debate, of course, about what that may mean for the future. But it's pretty good historically, right?

After all, the index was below 1,000 as recently as the early 1980s. It peaked at 381 just before the great Crash of '29. Despite the turmoil of the past couple of years, it looks like shares still rise over time, yes?

Not so fast.

When we look at the Dow, our eyes are playing tricks on us. I'm not just talking about the fact that the index is changed from time to time, as some companies replace others. Over the long term, it's been a pretty decent tracker of share prices.

What I'm talking about is the hidden role of inflation. It's the great sneak thief of money. Too many investors overlook it. If the Dow doubles in dollar terms, but your dollars halve in value, you may look like you've made progress but you haven't made any.

What really matters is what you made in "real," or inflation-adjusted, terms. So as everyone talks about Dow 10,000, I decided to ask a rarely asked question:

Will the real Dow Jones Industrial Average please stand up?

To find the real Dow, I ran two experiments. And they produced some intriguing findings.

First, going back to the late 1920s, I converted past levels of the Dow into 2009 dollars. I used the official inflation data, the Consumer Price Index, tracked by the U.S. Department of Labor.

You can see the results in Figure 1.

By this measure, Dow 10,000 doesn't seem that impressive after all. The index got close 6,700 -- in today's dollars -- as long ago as 1966. Indeed it was nearly 5,000 all the way back in 1929, just before the crash. Once you take out inflation, the rise in the index over 80 glorious years of American capitalism seems pretty tame.

Intriguingly, if you look at the chart through the mid-1990s it's hard to discern much of an upward slope at all. Yes, it's there, but it's very slight. This is hardly the soaring line, from bottom left to top right, that we are used to.

The graph raises a question. Something obviously happens in or around 1995. The index suddenly and visibly breaks out of any long-term trend and goes vertical. It enters a new phase or era -- call it what you will -- that has scarcely ended.

There are several possible explanations. Maybe shares really did become much more valuable than they did before. Or maybe investors just suddenly discovered that value.

For the sake of logical completeness, both of these explanations have to be considered, even though most market veterans will snort with derision. Why would this happen, and so suddenly? The explanations sound ominously like the "new era/new plateau/this time it's different" arguments that have buried legions of investors over many decades.

Two other explanations suggest themselves.

A new bubble

The first is that around 1995, the market suddenly entered a bubble. The bubble argument is so well known now, and so well established, that I'm not going to waste your time repeating it. Events of the last 15 years have surely made the "irrational exuberance" case pretty well.

But if the chart of the Real Dow shows a bubble which began in 1995, it raises the alarming suspicion that this bubble is far from over. Long-term trend lines might put you at around Dow 6,000 or Dow 8,000 today, but Dow 10,000 looks above trend.

And as Ben Inker, head of asset allocation at fund giant GMO recently pointed out to me, stocks have spent so long above long-term trends that logic, and historical experience, would suggest they are likely to spend more than a few days last March below it.

There is an alternative explanation for the way shares suddenly entered a new trajectory in the mid-1990s. It's that our eyes are deceiving us once again.

Why?

Calculation changes

Most people don't realize it, but for the past few decades successive governments have made changes to the way the traditional Consumer Price Index is calculated. The changes have been technical. Many, on their own, were minor. But cumulatively and over time, they have been more substantial.

Some economists argue the changes are improvements. They say the earlier numbers overstated inflation. Others take the opposite view, and argue the changes now mask the real inflation rate.

It's a normative debate. If the price of steak goes up but ground beef goes down, people are likely to eat more ground beef and less steak. Are they better off, worse off or about the same?

The more interesting question here is what it means for the "real" value of share prices.

The Labor Department no longer publishes the traditional CPI numbers, but an independent economist, John Williams at Shadow Government Statistics, produces an estimate each month. He's backdated them to the 1970s.

That lets us calculate an alternative "real" Dow, based on the traditional CPI, free of any changes in statistical methodology, political gerrymandering or government improvements.

The results are in Figure 2. They make an intriguing picture.

The 1995 dogleg is far less pronounced than before. And now the upward slope of the chart seems very muted.

Do shares really rise over time? The Dow just looks like a very stormy sea, marked by long, gigantic waves and crashes. Maybe the only thing rising over time is the size of the waves.

As for Dow 10,000, this now seems like very small potatoes. By this measure we were up near 28,000 -- in today's money -- back in 1999. We were over 20,000 in today's money back in the mid-1960s, and above 14,000 as long ago as 1929.

Which view is right? There is no definitive answer.

But these analyses do raise a timely reminder of the importance of dividends. Focusing on just capital gains -- Dow 10,000 and all that -- is deeply misleading.

Paul Marsh, professor at the London Business School, notes that the Dow only tracks a percentage of the U.S. market and may not capture all the long-term capital gains. But, he adds, the bigger issue is that long-term investors need to focus on dividends, not merely capital gains, in the first place.

"For a truly long-run investor, their return is dominated by dividends and dividend growth," he says.

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